LEGL 4700

History of Fintech

1980s: Introduction of Computers allowed for faster processing 1990s-2000s: Period of Financial Innovation, electronic stock trading, securitization, complex credit derivatives, Credit Default Swaps, government supported deregulation 2008: Financial Crisis, government began to place more restrictions for securities and in banking.

Circuit Split around HFT

3rd and 7th Circuits: manipulation must consist of illegal acts and not merely lawful trading with an improper intent to manipulate the markets DC and 2nd: lawful trading executed with an illicit manipulative motive is unlawful under 10B (regulatory action follows this circuit)

Utility Tokens

A digital asset that provides access to a product or a service Ex: Pocketful of Quarters and Turnkey Jet both got No Action letters from the SEC

Administrative Law

A government body authorized to implement legislative directions by developing more precise and technical rules than possible in a legislative setting.

What is money?

A unit of account Medium of Exchange Store of Value

Proof of Stake

A users stake of digital assets

Enforcement

Agencies exercise their investigating and adjudicating functions to enforce regulations Tools: Investigations Civil and Criminal Actions Cease and desist letters - violator must stop objectionable activity and refrain from any further violation Consent Orders - agreed upon by the accused and requires the accused to waive rights to judicial review

CFPB Consent order with Paypal

Alleged that Paypal had signed up customers for its credit product without their permission and charged deferred interest: illegal billing practices Paypal agreed to a consent order that entitled users to $15M a $10M Civil Penalty and required improved disclosures

Permissioned

Allow only designated authorized people to participate in building consensus and validating transactions

Licenses and Charters

Allows firms to engage in specified activities with heightened control and restrained circumstances Ex: National Bank Charter, Fintech Charter, Payments Charter

Pilots

Allows regulators to design and oversee tests involving new innovation or techniques, observe outcomes, and then tailor rulemaking to its most efficient and effective form Ex: CFPB Project Catalyst and disclosure sandbox, OCC innovation pilot program

Dodd Frank Act of 2010

Amended the Commodity Exchange Act Specifically makes spoofing unlawful CFTC rules promulgated pursuant to clarity that the CFTC need on prove that the trader intended to cancel the orders Empowered the CFTC to promulgate rules to prohibit practices that are disruptive of fair and equitable trading

SEC Frameworks for Digital Assets

As Stocks, Digital assets do not: Evince rights to ownership, provide owners with a right to participate in the profits of a project, or provide a right to vote As bonds, they do not result in an obligation of one party to pay another As investment contracts, the Digital Assets can be considered a security

Potential Regulatory Frameworks for Digital Assets

As securities regulated by the SEC Or as commodity interests regulated by the CFTC

Decentralized Digital Asset Trading Venues

Assets are traded directly on a blockchain Transactions take more time SEC yet to address issue

Commodity Exchange Act

Authorizes CFTC regulation of transactions involving commodity interest, commodity very broadly defined

Regulatory Sandboxes

Authorizes businesses to test their innovative products, services, business models, and delivery mechanisms in the real marker, with real consumers, on a trial basis Reduces time to market at a low cost, improves access to capital and ensures adherence to compliance requirements Allows direct communication between Fintech and regulatory officials while mitigating the risk of unintended negative consequences such as security flaws Ex: Financial Conduct Authority launched the Innovation Hub in the UK, Arizona Nevada and Utah all have state regulatory sandboxes

Different Types of Cryptocurrenices

Bitcoin (main one) "Altcoins" (not bitcoin): Etherium, XRP Stablecoins (Tether)

State regulated exchanges

Bitlicense (NY state department of financial services: Must have a US subsidiary, must demonstrate established business plan, financial control and compliance officer Trust of Limited Purpose Trust: must satisfy the same requirements as NY state chartered banks but cannot accept deposits, allows venue to operate without a state money transmitter license, cannot exchange securities

Traditional Exchange Intrastructure

Buyers and sellers place orders with brokers Brokers were then required to immediately trade at the best possible price

SEC vs. Howey

Case resulted in the Howey Test, to determine whether an instrument is an investment contract for the purpose of the Securities Act. "a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party."

SEC Justifications for suing Ripple

Common Enterprise: Ripple did not mine its coins, 100B created at once Ripple owns 6.4B with 48B in reserves 40% of the nodes that validate the transactions are owned by Ripple Ripple funded its operations with the sale of XRP Ripple exerted effort to manage the price Expectation of profit based on efforts of others: Ripple promoted XRP as a speculative investment

Agencies power from

Congress which makes laws and those laws set up agencies

Derivative

Contract between two or more parties whose value is based upon an agreed-upon underlying financial asset

Consumer Financial Protection Bureau

Created by the Dodd Frank of 2010 Enforces and promulgates rules related to prohibitions against unfair, deceptive and abusive acts and practices Holds primary regulatory authority over a wide range of activities relating to consumer products, including mortgages, credit cards, mortgage loan servicing, debt collect and others Supervises certain non-bank financial companies, large banks, and credit unions with over $10B AUM

Securities Exchange Act of 1934

Created the SEC Regulates transfer of securities after initial sale Makes it illegal to sell unregistered securities on a national exchange Imposes civil and criminal liability for fraud in exchange of securities

US vs Coscia

DOJ alleged that Coscia used a HFT program to manipulate the commodities markets by placing large orders that were programmed to cancel before they were executed

High Frequency Trading

Denotes a range of technical operations designed to facilitate the speedy and successive input of buy and sell orders on stock markets

Stable Coins

Digital Asset pegged or collateralized by a stable asset (USD) Ex: Tether, Maker DAI coin, Libra (facebook)

Digital Wallets

Digital Wallet providers can be treated as broker-dealers, transfer agent, or clearing agent Subject to SEC oversight

Digital Currency Exchange

Digital currency exchanges are crypto version of a stock exchange Technically a venue unless registered as a national securities exchange with the SEC A platform for buyers and sellers to trade digital currencies Blockchain transparency institute (BTI) has verified 9 exchanges

Digital Asset

Digital representations of value that use distributed ledgers, called blockchains, to memorialize transfers of ownership and other transactional information

Direct Feed and Co-Location

Direct feeds bypass the national system and are sold directly to those who are willing to pay for access (allowing HFTs to get pricing information faster than the market) Regulation NMS created a national consolidated data feed called the Securities Information Process and prohibited broker dealers from providing direct feed access sooner than the data in SIP Co-location brings servers closer to the data and markets to receive information faster SEC must approve exchanges offering co-location in the trading center

Informal Guidance

Does not necessarily obligate authorities to permanently condone nor prohibit any particular course of action Ex: CFPB No action letter issued to UpStart

Federal Trade Commission (FTC)

Established by the Federal Trade Commission Act Enforces congressional prohibition against unfair and deceptive acts or practices Enforces anti-trust laws (Clayton Act) Investigates and prevents deceptive trade practices

Ether

Ether is referred to as Altcoin because it is not bitcoin Created in 2014 by Vitalik Buterin Ethereum Foundation supports the blockchain and ethereum related technologies Smart contracts enable users to program instructions for the transfer of ether Allows applications to be built on top of the Ethereum Blockchain 1 Ether = 21000 Gas No cap on Ether

Reves Test

Family resemblance test to see if something is a security, can be applied to notes

US vs Milrud

Federal prosecutors charged Milrud with violating Section 10B by spoofing Pled guilty to conspiracy to commit securities fraud

Digital Asset Exchanges

Federally regulated alternative exchanges Registered with the SEC Regulated as a broker dealer and must register with FINRA Must have reasonable policies to prevent misuse, meet recordkeeping requirements and comply with rules to safeguard customer funds and information Prohibited from using exchange in the names

Implications of Electronification of the Markers

Fracture of the market structure Incentivization of greater speeds Automation of trades via algorithms

Blockchain Governance

Hackers stole 55M in DAO tokens built on Ethereum's blockchain Ethereum core developers modified the blockchain to invalidate the attackers future transactions Not all users updated their software and continued to use the older software called Ethereum Classic

Digital Asset Forks

Hard Fork: Modification to the blockchain protocol that makes new transactions invalid on the pre-existing chain Soft fork: Newly forked chain adds to the preexisting protocol

Digital Asset Investment Funds

Investment Company Act requires registration with the SEC and imposes investor protection measures: Sufficient cybersecurity protections Establish a liquidity risk management program Assets must be valued each business day

Howey Test: Is this a security?

Investment of Money In a common enterprise Based on a reasonable assumption of profit Derived solely from the efforts of others

DAO ICO and the SEC

Investment of Money: Ethers Common Enterprise: Investors pooled their resources into venture capital funds Expectation of profit: DAO could pay dividends Efforts of others: Identification of profitable startups by sponsors

How Rulemaking agencies are reviewed

Is the delegation constitutionally valid? Must be definite and limited. Has the agency exceed its authority?

Problems with the Howey Test

It is not a great fit especially when cryptocurrencies change form over time The subjectivity of the test gives the SEC a lot of power

Stub Quotes Restriction

Limits offers to buy and sell at prices that are so far away from the prevailing market that they are not intended to be executed (prevents spoofing and volatility)

Fraud Enforcement and Recovery Act

Lowered the standard for proving guilt from willful to knowing for securities fraud and manipulation for criminal sentences of up to 25 years

Sarbanes Oxley Act

Lowered the standard for proving guilt from willful to knowing for securities fraud and manipulation for criminal sentences of up to 25 years Willful = requires knowledge that the act is illegal Knowing = only requires that the act be voluntary and intentional

Section 4 of CEA (CFTC Antifraud)

Makes cheating and defrauding in connection with any commodity futures contract used for hedging price discovery or delivery of a commodity unlawful

Section 6 of the CEA (CFTC anti fraud/ manipulation)

Makes employment of any manipulative device or scheme or artifice to defraud in connection with any swap or contract of a sale or security

Commodities Exchange Act

Makes fraud and manipulation in the exchange of certain derivatives (futures and swaps) and commodities unlawful Gives CFTC power to regulate both

Circuit Breakers

Mechanisms that react to extreme market volatility by pausing trading activity Used by the SEC since 1988 Following the Flash crash of 2010, the SEC expanded use so that the exchanges are required to stop trading if a stock price moves up or down by 10% over a 5 minute period Expanded again to include market wide circuit breakers if a severe price decline reaches levels that may exhaust liquidity (7% drop in SP 500) CFTC requires that designated contract markets to have controls in place that pause or halt trading to address market disruptions and emergencies

Use of Digital Assets

Money Utility Tokens Security Tokens

Factors Leading to the Fintech Boom

More regulation of banks through the Dodd Frank Act Growing distrust of banks due to mismanagement that came to light during the Financial Crisis (CDS) Growing distrust of the financial system due to massive bailouts in 2008-2009 (taxpayers were bailing out private institutions) Technological improvements including increases in processing speeds and decrease in the cost of data storage Widespread use of smartphones

What is new about Fintech

New data: websites, social media and databases provide new data. More data is stored online, more technological data is available, cloud systems. There is so much more than centralized data to use Automation of financial markets, artificial intelligence, and machine learning Disintermediation of incumbent architectures: Innovation is often driven by small startups who's specialty resides in technology instead of finance. They target discrete parts of the financial supply chain instead of whole financial services.

HFT Strategies

Passive: Market Making - profit from spread between bid and ask prices Arbitrage - exploit differences in stock prices across exchanges Aggressive: Order anticipation - purchase ahead of institutional investors order and sell it for a higher price Momentum ignition - trades are initiated aimed at causing price changes Spoofing - rapid submission and cancellation of orders to trigger other algorithms and thus affect prices

CFTC Regulation

Powers: Antifraud Anti Manipulation Regulation of Exchanges

Limit up-limit down rule

Prevents trades from occurring at price points outside a band calculated a percentage above and below the securities average price over a 5 minute period to prevent extreme volatility

Commodity Futures Trading Commission (CFTC)

Primary regulator of derivative markets Mission is to protect investors and individuals who rely on derivatives subject to the Commodity Exchange Act from fraud, manipulation, abusive practices, and systemic risk Oversees futures markets where individuals contract to deliver cryptocurrencies that are not securities

Opinions about HFT

Pro: Enhances the market liquidity, execute many trades, consider themselves market makers Con: increases market volatility, contributes to flash crashes, allows slower retail investors to be taken advantages of, provides a means of market manipulation 2010 flash crash caused market to dip $1T over a span of minutes

Prosper and the SEC

Prosper notes are securities under the Reves Test because: Prosper lenders are motivated by an expected return on their funds The prosper loans are offered to the general public A reasonable investors would likely expect that the Prosper loans are investments There is no alternative regulatory scheme that reduces the risks to investors presented by the platform

Reasons for Agencies

Provide Specificity Provide Expertise Provide Protection Provide Regulation Provide Services

Dodd Frank Act

Purposes of the act include to protect consumers from abusive financial services practices

Telegram Interactive and the SEC

Raised 1.7B from the sale of digital tokens called Grams to accredited investors SEC sued to stop sales Federal court issued injunction saying that the sales to accredited investors were part of a larger scheme to distribute the tokens on the secondary market SEC filed a complaint Settlement for $1.2B to investors and $18.5M to settle SEC charges

National Securities Exchange

Registered with the SEC as a national securities exchange More onerous compliance requirements Must participate in the national market system, which requires fair and equal access to oders Advantages: NSEs may operate more autonomously No crypto venues have registered as NSEs

Securities and Exchange Commission

Regulates the sale of securities by firms that create new financial tech as well as the myriad of fintech firms that trade

Pros and Cons

Regulatory authority needs to balance between certainty and flexibility There are exemptions from some regulations

Rule 613

Requires NSEs to create a consolidated audit trail that captures order event info across all markets

Securities Exchange Act of 1933

Requires disclosure of information to potential investors Applies to the initial sale of a security Information must not be untrue or misleading Sanctions include criminal punishment, civil liability, or equitable remedy of an injunction

Large Trader Reporting Rule

Requires high volume traders to register with the SEC and receive a unique tracking identifier

Federal Reserve Board

Responsible for US monetary policy and supervision Oversees Banking holding companies and their non-bank subsidiaries Savings and Loan holding companies State chartered federal reserve member banks Foreign banking organizations in the US Other systemically important institutions 12 districts

Why Ripple is an investment contract

Ripple did not mine its coins, XRP created 100M all at once Ripple owns 6.4M Another 48M are held in reserve

SEC vs Athena Capital Research

SEC imposed sanctions against Athena for manipulating NASDAQ stock prices by executing a large number of rapid trades in the final two seconds of every trading day over a 6 month period Evidence of intent: emails indicated that the purpose of the trades was to move the stock prices "Lets make sure we don't kill the golden goose"

Market Access Rules

SEC rules 15C3-5 eliminated direct exchange access for HFTs Prior to this rule, HFT firms arranged with brokers to directly access the exchange (to execute trades more quickly than the rest of the market)

Ether and the SEC (Howey)

SEC said Ether is not an investment contract. There is an investment of money, in a common enterprise (Ethereum Foundation), with the expectation of profit. It is not derived solely from the efforts of others because of the subsequent transfers of Ether

Bitcoin and the SEC (Howey)

SEC said bitcoin is not an investment contract There is an investment of money and an expectation of profit. There is not a common enterprise and it is not derived solely on the efforts of others.

Who Regulates Fintech

SEC, CFTC, The Fed, CFPB, FINRA, OCC, FTC, FinCEN

Bitcoin

Satoshi Nakamoto authored a white paper in 2008 titled "Bitcoin: A peer to peer electronic cash system" Release bitcoin software in 2009 and launched genesis block 0 Employs the bitcoin blockchain to record and memorialize transactions using proof of work consensus Bitcoin are mined using Bitcoin protocol and miners rewarded in Bitcoin 1 Bitcoin = 100M Satoshis Capped at 21 M Bitcoin

34 Act and HFT

Section 10B broadly prohibits the use of manipulative and deceptive devices or scheme in securities transactions

Financial Industry Regulatory Authority (FINRA)

Self regulating organization Regulates brokerage firms and exchange markets in trading equities, corporate bonds, securities, future, and options Establishes rules under which their members must conduct business and sanction members when they violate those rules

Role of States

Set additional standards for any additional state benefits above and beyond the federal baseline Usury law State licensing requirements NY State Dept of Financial Services have a specific license for cryptocurrencies

Kik Interactive and the SEC

Sold digital token called Kin Presale through SAFT agreements with 50 accredited investors at a discounted price Later token distribution with 10000 purchasers for $49.2M worth of Ether SEC filed action alleging Kik sold securities in violation of securities regulations Federal District Court granted summary judgement in favor of the SEC because two events constituted a single integrated offering and thus the presale was not eligible for the exemption

The Regulatory Toolbox

Statutes and Regulations Enforcement Licenses and Charters Regulatory Sandboxes Pilots Informal Guidance

Statues and Regulations

Statutes are enacted by Congress Regulations are promulgated by agencies after a notice and comment period Equal Credit Opportunity Act is a statue, Regulation B is a regulation

Stablecoin

Tether: initial coins were on the bitcoin blockchain, newer coins on Ethereum Maker DAI coin: ERC20 token on the Ethereum blockchain

XRP and the SEC (Howey)

The SEC said XRP is an investment contract and sued Ripple for selling unregistered securities There is an investment of money, in a common enterprise (Ripple Labs), with the expectation of profit, and it is based on the efforts of others. The owners admitted that buyers were purchasing for speculative purposed and the success of XRP is based on Ripple's performance

XRP

The native currency employed by Ripple Labs in 2012 Peer to peer open source ledger that uses consensus mechanism that validate transactions 1B XRP are released per month Ripple offers means to bridge fiat currencies between different financial institutions Capped at 100B XRP

Reves Test

The sellers and buyers motives The plan of distribution (suggesting potential speculation by purchasers) The reasonable expectations of the investing public The availability of an alternative regulatory regime

Distributed Ledger Technology (DLT)

This is a common term used to describe blockchain technology, especially as used by private enterprises. Ex: Bitcoin and Etherium

Simple Agreement for Future Tokens (SAFT)

Tokens are sold to investors initially Once the company is operable, then tokens are sold more widely. The are investment contracts but are sold through Regulation D and thus avoiding SEC registration

security token

Tokens that pass the Howey test and are registered as securities Subject to registration and disclosure obligations (33 act) Registration statement must be approved by the SEC Can only be traded on platforms and entities licensed to trade in securities (unless the issuer can satisfy one of the private offering exemptions) Ex: Accredited investors (200k in income or $1M net worth under REgulation D)

Financial Crimes Enforcement Network (FinCEN)

U.S. Treasury system in which Suspicious Activity Reports are sent to if a broker-dealer notices activity in accounts appearing suspicious or possibly related to fraud or money laundering activities. Administers the Bank Secrecy Act Housed with the Treasury Department

Characteristics of HFT

Use of high speed and sophisticated computer programs to generate route and execute orders Use of co-location services and data feeds to minimize network latencies Use of short time frames for establishing and liquidating positions

Initial Coin Offering (ICO)

an unregulated means by which funds are raised for a new cryptocurrency venture Means to raise capital by providing digital asset tokens to investors Launces with a white paper providing an overview of the project Made possible through the EC20 Protocol

Office of the Comptroller of the Currency (OCC)

charters and regulates national banks

Manipulation

employing a device or scheme to alter the price of the asset

Contrivance

plan or scheme

Fraud

providing false or misleading information to customers